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THE SKIM AND THE PARTIAL PONZI: PART II

“An investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk.”

A Partial-Ponzi, is the lower than advertised Return On Capital (ROC)1 that most publicly traded corporations in America are achieving.

Though I previously highlighted a new phenomenon of disappearing earnings (45%), the real story is how money is being skimmed by the executives of corporate America, in return for which the rest of us are not really getting any value-added for this munificence. While Wall Street gets the blame for financial excess and ruin (and ruinous practices)2, the major driver of income inequality is being led by publicly traded corporations – those supposedly owned by all of us in our savings and retirement accounts.

One easily understandable example of how a company may be coming up short on its real ROC and thus committing a Partial-Ponzi, is what I call the three-steps-forward-one-step-back. This is where a company has great returns for several years, followed by a horrible one that makes the average annual return for the whole time period substandard. Financial companies are well known for this. Think of an insurance company that underwrites a lot of a specific type of insurance by underpricing it. For X number of years they book as earnings all the premiums, only in year X + 1 to have to give it all back when the claims come in much higher than they actuarially assumed. Plenty of non-financial companies have their own version of this. Maybe they make a big capital investment, or even an acquisition, based on projections of profitability several years out. Whatever the underlying shortfall, executives of publicly traded companies still receive full bonus compensation for the ‘untouched’ years (there’s no give-back), very frequently receive 50% or more of “bonus” compensation in the really bad year as a ‘participation-trophy’ for giving it their best shot, and usually keep their jobs only to pull the 3-forward/one-back again and again. And if they don’t keep their gig, they usually get a special departure bonus and benefits whose cost to the company and shareholders usually eclipses the total lifetime earnings of the average company worker (I’ll try not to get all Marxian on you – instead feel free to substitute average small businessman).

Another great example is that of tech companies not including option expenses under the rationale that they don’t require a cash outlay and the inability to predict if or to what extent they’ll be in the money. Huh? If I tell you that you can have 25% or 50% of company X’s value above a certain threshold anytime over the next decade, there’s definitely a value to that, and probably a lot more than you’re willing to admit/expense. In recent years, I believe this has been the largest component of the Partial-Ponzi shortfall, as mega-tech companies have dominated the market-cap weightings of the S&P 500.

One more technique to falsify the real ROC, is not including non-recurring or one-time expenses in compensation formulas. Finally there’s a whole cornucopia of additional cover and excuses that corporate boards and management use to justify compensation formulas such as: extraordinary market/economic conditions, restatements, reclassification of losses or terms (or just no longer include), weather, etc. .

Whatever the newfangled rationale created by executives, boards, and compensation consultants for mediocre returns, the percentage being skimmed by the executives keeps growing bigger, further exacerbating the lower return side of the equation over the long term. I think it occurs to a much greater extent than is outlined in proxies, and only shows up when looked at many companies in aggregate.

Going through individual proxies and trying to ascertain the real compensation costs for every company is nearly impossible. On the one hand every company’s formula is different, like a fingerprint, and on the other hand, no company will lend you a full day with their accountants in order to get the explicit detail needed to ascertain it.3 In light of this, I’m sticking to my conservative estimate of 25% of net income being skimmed, and falsely being accounted for, as gleaned from the inability of the S&P 500 to reduce the number of shares outstanding despite the huge percentage of reported net income spent on share buybacks, as elucidated previously.

As for public companies, the reduced ROC means there is no value added in having CEO X (& team) vs. CEO Y. Quite simply, too many top executives are getting superstar pay for blocking and tackling. And I believe that the skim and the Partial-Ponzi are the main reason for income inequality today.

Unfortunately the insidious manner in which it has occurred and is occurring, happens over a very long time period and is dependent on a concept that most people are aware of, but not concretely: the power of compounding. So here’s that concrete example. Assume one has a savings portfolio worth X and it earns 8% a year. After 40 years it will have a value of 21 times X. Now, if corporate management skims 1% of that every year in unjustified excess compensation, you then earn 7% a year, which after 40 years has a value of 15 times X4. In other words, over 40 years, there has been a wealth transfer from anyone who has a savings portfolio of stocks, of over 25% of peoples total net worth (21-15 divided by 21 = 28.8%). Whilst you’ve been like a frog in a pot of boiling water, it’s gone out of your pocket and into that of another. In a nutshell, there’s your problem5.

Worse, whether it’s 1% or 2%, the skim is an absolute percentage. Thus in times of ultra low return expectations, such as today, it’s effects on savers grows tremendously in terms of the percentage bite being taken out of their savings.

If you’re young and think none of this matters, then be prepared for an ignominious end. There you’ll be at the inferior Senior home, with the mean nurses and rats and your offspring with no hopes. Therefore something better be done by the doctors & lawyers & accountants & small businessmen & …yes unions as shareholders in these corporations, before the wealth transfer becomes so great that it also becomes a power transfer, as collectively the minority shareholders also lose majority control, and the little guy no longer has a vote that matters.

Stay tuned for more on the Skim and the Partial Ponzi, including the solution…

or similarly Internal Rate of Return (IRR), or the derivative but far from identical Return On Equity (ROE), etc. [↩]

yes, I know that there are many other reasons for increased income inequality, including the proliferation of hedge funds, private equity firms, and finance in general, also the ‘superstar++’ theory, but I think this has more validity than Piketty’s rationale too, and I think the skim is greater than 1% -> the transfer in wealth being > 25% [↩]